Article written by Bennie A. Wall, Esq.
“In this world nothing can be said to be certain, except death and taxes.”
– Benjamin Franklin
It seems that one of the most common questions I get from clients is how will their estate be taxed when they pass. I anticipate that these questions will only increase with the attention brought by the most recent tax reform under the Trump administration.
This article will serve as a primer on the most common Wealth Transfer Taxes with updated information from the Tax and Jobs Act of 2017.
Types of Wealth Transfer Taxes
There are four types of wealth transfer taxes: the Gift Tax, the Estate Tax (sometimes referred to as the “Death Tax”), the Inheritance Tax, and the Generation Skipping Transfers Tax.
The Gift Tax
Gift Tax—Gift taxes are imposed on certain transfers made to any individual for less than full and adequate consideration (measured in money or monetary value)—more simply, when you do not get the full fair market value for an item. There are some exclusions from this general rule. Generally, the following gifts are not taxable gifts:
- Gifts that are not more than the “annual exclusion” for the calendar year.
- Tuition or medical expenses you pay for someone (the educational and medical exclusions).
- Gifts to your spouse.
- Gifts to a political organization for its use.
- Gifts made to qualifying charities without receipt of goods or services in return.
Any gifts made that are not excludable or deductible, will first draw upon your “basic exclusion amount,” which is treated as a credit for gift tax purposes. For example, if you have an 11.2-million-dollar basic exclusion amount in 2018 and you make a gift to your sister of $100,000, you have made a taxable gift of $85,000 ($100,000 given to your sister less your $15,000 “annual exclusion” for 2018). Your tax liability on the gift would be $0.00 because your “basic exclusion amount” would be applied. You are now left with 11.115 million dollars of exclusion (11.2 million less 85,000).
The Estate Tax
Estate Tax—Sometimes referred to as the “death tax,” estate taxes are charged against the estate of a deceased taxpayer. The federal government imposes an estate tax on America’s wealthiest individuals—some estimates citing that less than .2% of Americans are affected; however, some states will impose their own estate tax and will be much less forgiving than the federal government. Virginia, however, is for lovers and does not impose an estate tax.
The Inheritance Tax
Inheritance Tax—not to be confused with the estate tax—is a tax on the inheritance and charged against the beneficiary of an estate and not against the estate itself. The federal government does not impose any form of inheritance tax—the Revenue Code is clear that any receipt of property from a deceased person is not considered income. The inheritance tax is only at the state level, so it is important to consider where your potential beneficiaries may reside when determining the best method for leaving an asset to them. Again, Virginia does not impose an inheritance tax.
The Generation Skipping Transfer Tax
Generation Skipping Transfer Tax – This is a more complicated tax that comes into play when you make lifetime gifts or testamentary bequests to a generation below your children. It was designed to keep the ultra wealthy from passing down money for several generations while escaping taxation. Essentially, it is a way to ensure that when you skip a generation, you are taxed similarly as you would have been had you left it to the generation directly ahead.
Some other important terms to know:
American Tax Relief Act of 2012, or “ATRA”: This Act was signed into law by President Obama in 2013. The main take-aways about this act for estate and gift taxation are: (1) it made permanent many of the tax reduction or deduction provisions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001; (2) it set the “basic exclusion amount” at $5,000,000 to be adjusted for inflation; and (3) it allowed married taxpayers to “port” their basic exclusion amounts.
Annual Exclusion: The annual exclusion is the amount that a taxpayer may gift to any individual in a tax year without incurring any gift tax liability. For 2018, this amount is $15,000. So, if you give your brother $15,000, there is no need to worry with a gift tax return; however, if you give your sister $16,000 you will need to speak with your accountant about filling a gift tax return this year.
Basic Exclusion Amount: The basic exclusion amount (or applicable exclusion amount) is the amount that we may pass either during life or upon death without having to pay any tax liability. In the 1990’s this amount was moving between $600,000 and $1,000,000. The ATRA raised this amount to $5,000,000 to be adjusted for inflation. In 2017, this meant that every taxpayer had a 5.49 million dollar exclusion that they could pass on without paying a dime in estate taxes. The Tax and Jobs Act of 2017 has provided for a $10,000,000 exclusion to be adjusted for inflation, giving each individual 11.2 million dollars in 2018. It is important to note, however, that this rise in the basic exclusion amount is temporary and is set to drop back down to the $5,000,000 (adjusted for inflation) rate in 2025 if Congress does not renew the plan.
Portability: Portability solved a very complicated issue many married couples faced. Before the ATRA was enacted, it was very important to use estate planning to preserve a deceased taxpayer’s basic exclusion amount. Otherwise it was lost forever upon death and the taxpayer’s estate was subjected to more taxation. This often led to complicated trust planning that was designed to shield the credit amount form estate taxation. Unfortunately this led to assets being locked down in an irrevocable trust for the surviving spouse and children. Also, any assets appreciating over the lifetime of the surviving spouse were building up capital gains to be passed on to the ultimate beneficiaries of the trust. The ATRA allows married couples who make a timely election to port their unused basic exclusion over to the surviving spouse. This will ensure that the amount is preserved and can now be passed on by the surviving spouse to the next generation. Since the surviving spouse has full control over the assets until she passes, the assets will receive a step up (or down) in basis to the fair market value of the assets as of her date of death. This has allowed many to have much simpler estate plans and administration.
The Federal Estate and Gift Taxes work together. Each taxpayer has a basic exclusion amount. Married couples may, through portability, draw on each other’s basic exclusion amount. A surviving spouse may elect to add the deceased spouses unused exclusion amount, but a timely election must be made. Every gift a taxpayer makes above the annual exclusion is credited against the taxpayer’s basic exclusion amount (or applicable exclusion amount). When a taxpayer passes away, the executor will use the remaining basic exclusion amount (or applicable exclusion amount) to pass the rest of the assets in the estate to its beneficiaries. If after accounting for lifetime gifts there remains an exemption amount, then the taxpayer will not owe any estate taxes. However, if the exemption amount is not sufficient to cover the full bequests, there will be some tax levied against the estate.
If you are concerned about potential tax consequences of your estate plan or lifetime gifting plans, I encourage you to reach out to an experienced estate planner and a trusted tax professional today. Together we can create a plan that best meets your goals and minimizes or eliminates adverse gift and estate tax consequences.